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OSC head leans to the negative about high-frequency trading

The TMX broadcast centre.


Howard Wetston, the head of the Ontario Securities Commission, believes that markets are fundamentally for long-term investors. That's not a good sign if you are a high-frequency trader wondering what policy makers are going to do to your strategy of flipping Canadian stocks.

Mr. Wetston, who has led the country's most powerful market watchdog since 2010, has reached no final conclusion on the effects on markets of high-frequency trading, one of the hottest topics in financial market regulation. But it is very clear from spending an hour with him in his office, 17 floors above downtown Toronto, that his philosophical starting point is hard to square with the idea of traders using super-powerful computers to churn millions of shares in milliseconds in a bid to capture tiny bits of profit that add up fast.

"The purpose of capital markets – if you take out the profit motivation, the greed – what they are there for is to support long-term growth and value to market participants and investors," Mr. Wetston says.

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He pauses, then says "I emphasize 'long term,' " before going on to state that "we have fallen into short-termism."

High-frequency trading is the shortest-term activity of all. HFT encompasses multiple strategies, but generally involves buying and selling shares in fractions of a second to capture small price discrepancies or rebates offered by marketplaces seeking trading volume. By Mr. Wetston's definition, they are not really "investors" at all – many such trading shops own no shares overnight.

High frequency activity is now behind as many as 42 per cent of all Canadian trades, according to a study led by the Investment Industry Regulatory Organization of Canada (IIROC), with which the OSC is collaborating on research into the activity.

From 2010's "Flash crash" that sent stocks tumbling one spring day to this summer's debacle at Knight Capital, which lost $400-million in half an hour, HFT is in a harsh spotlight. The sense that markets are unstable at best, and rigged at worst, is eating into investor confidence. Events such as the Flash crash, which was blamed on electronic trading, "are crystallizing into a situation that suggests some form of regulatory response would be required," Mr. Wetston says.

But what is that response? And just as importantly, how tolerant should Canadian regulators be of the risks of such trading?

"We ask ourselves the fundamental question: Is this type of trading actually consistent with what we expect of financial services and financial markets?"

Proponents of high-frequency trading argue that it means lower costs for investors by shrinking the spread between bid and ask prices – the offers to buy or sell stock in the market. Opponents say that's an illusion, as all too often an HFT shop will post a bid or ask price to fish for information, and the quote disappears when an investor tries to act on it. The critics say HFT players cost long-term investors money, and bring little to the table in return.

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The OSC regulates most Canadian stock markets, including the Toronto Stock Exchange. Because of that, the commission will play a key role in any rules that are put in place.

The regulators are in the midst of a deep dive into the computerized world of Canadian trading to try to determine whether high-frequency trading (HFT) is helping or hurting this country's markets. Working with the securities industry's self regulatory body, IIROC, the OSC is combing through millions of trades to try to isolate HFT strategies and determine if some are predatory. The first cut of the data was released this summer, showing just how deeply HFTs have infiltrated the Canadian market.

Mr. Wetston says he looks at the situation by asking two questions rooted in the regulator's mandate. Do activities help or hurt market quality and market integrity? Market quality is the way markets work, in terms of delivering on their promises to investors of being open, fair and efficient. Market integrity means ensuring cheaters are kept out.

In a game that is all about speed, the issue for any regulator is going to be keeping up. The OSC and IIROC are looking at trades from 2011 in their examination of HFT's effects. The final report from that review is months away. Then the regulators will have to try to put in place a policy response, which in Canada's fractious regulatory world can take many more months. The risk is that regulators will finally unveil rules in 2014 based on what was happening in 2011, an epoch ago in the ever-evolving word of trading.

Mr. Wetston is very conscious of all that. And he constantly emphasizes that he does not have the answers yet. But for those in the HFT game, there's a clear warning shot coming from the offices of the OSC.

"I'm not persuaded that I see all the benefit in all of the trading," he says.

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Editor's note: The online version of this story was clarified to reflect the fact that the study of high frequency trading in Canada referred to in the text is being led by the Investment Industry Regulatory Organization of Canada at this stage. The Ontario Securities Commission will be more involved in the study in a later phase.

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